To calculate a stock's price-to-earnings ratio, an investor would need to know both the company's stock price and its earnings. These two pieces of information can be used to determine the P/E ratio of a stock which, in turn, will allow investors to gauge the relative value of the stock. The price-to-earnings ratio is determined by dividing the price of the stock by the company’s earnings. The price-to-earnings ratio is one of the most basic valuation metrics used when considering a stock for purchase, and is still widely used.
Which Earnings Number to Use
A commonly made mistake when calculating the price-to-earnings ratio is in selecting the wrong earnings number. P/E ratios compare the price of a stock to that company’s earnings. The most common price-to-earnings ratio is meant to compare the current price of the stock to the annual earnings. Since companies often report quarterly numbers, it is important to remember the stock P/E ratio requires an annual calculation. Once the proper earnings number is determined, the price-to-earnings ratio is found by taking the price of the stock divided by that earnings figure.
Forward Looking Versus Trail P/E Ratio
It is important for investors to understand what kind of stock P/E ratio they are looking at. A trailing P/E ratio looks at the company’s earnings for the previous four quarters. A forward looking stock P/E ratio considers projections as to what the expected earnings will be.
The forward looking P/E ratio only uses a projection for earnings, not the price. The trailing P/E ratio uses the actual numbers achieved by the company. While neither type of P/E ratio is necessarily better, the difference in each stock P/E ratio is important. The trailing P/E ratio is more accurate, while the forward looking stock P/E ratio gives you a better sense of what the future may look like.
Using Stock P/E Ratio to Invest
The price-to-earnings ratio is used to tell an investor how much they are paying for every dollar of earnings the company makes. It is believed that by comparing one stock P/E ratio to another, you can make a judgment as to which is a better value. But investors should also be cautious to comparing P/E ratio of companies in different sectors or industries, as the standard number can vary. It is best to use P/E ratio when comparing stocks similar in nature.